Bernie and Pam Britten are a young married couple beginning careers and establishing a household. They will each make about $50,000 next year and will have accumulated about $40,000 to invest. They now rent an apartment but are considering purchasing a condominium for $100,000. If they do, a down payment of $10,000 will be required.
They have discussed their situation with Lew McCarthy, an investment advisor and personal friend, and he has recommended the following investments:
The condominium - expected annual increase in market value = 5%.
Municipal bonds - expected annual yield = 5%.
High-yield corporate stocks - expected dividend yield = 8%.
Savings account in a commercial bank-expected annual yield = 3%.
High-growth common stocks - expected annual increase in market value = 10%; expected dividend yield = 0.
Calculate the after-tax yields on the foregoing investments, assuming the Brittens have a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003).
How would you recommend the Brittens invest their $40,000? Explain your answer.
Considering that in these tough financial times, the expected increases in market value, dividends, and interest are probably unrealistic, I'd put $20,000 into the condo and the rest into a money market or savings account. Also, there's no guarantee that they'll both keep their jobs. It's important to have money set aside that is easily liquidable.
I also would "fire" Mr. McCarthy as my investment advisor.
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To calculate the after-tax yields on the investments, we need to consider the tax implications for each type of investment. Let's calculate the after-tax yields step by step:
1. Condominium:
The expected annual increase in market value is 5%, but since we are looking for after-tax yield, we need to take into account the taxes on capital gains. With a marginal tax rate of 28%, the after-tax yield on the condominium would be:
5% * (1 - 0.28) = 3.6%
2. Municipal bonds:
Municipal bonds are typically exempt from federal income taxes, so the after-tax yield is equal to the expected annual yield of 5%:
5%
3. High-yield corporate stocks:
The expected dividend yield is 8%, but dividends are generally subject to income taxes. Considering the marginal tax rate of 28%, the after-tax yield on high-yield corporate stocks would be:
8% * (1 - 0.28) = 5.76%
4. Savings account in a commercial bank:
The expected annual yield is 3%, and interest income is subject to income taxes. Considering the marginal tax rate of 28%, the after-tax yield on the savings account would be:
3% * (1 - 0.28) = 2.16%
5. High-growth common stocks:
The expected annual increase in market value is 10%, but there is no expected dividend yield. Therefore, for this investment, we only consider the capital appreciation and not after-tax yield since there are no dividends.
Now, let's consider how to recommend the Brittens invest their $40,000 based on the after-tax yields:
- The condominium has the lowest after-tax yield of 3.6%. While it may be a good long-term investment due to its potential market value increase, the after-tax yield is not as attractive.
- Municipal bonds offer a tax-exempt yield of 5%. This could be a good option for the Brittens' portfolio as it provides a steady income stream and tax benefits.
- High-yield corporate stocks have an after-tax yield of 5.76%. While they come with higher risk, they offer a higher return potential.
- The savings account in a commercial bank has the lowest after-tax yield of 2.16%. It may provide security, but the low yield makes it less appealing for long-term wealth accumulation.
- High-growth common stocks should be considered separately for their potential capital appreciation, but they do not offer any after-tax yield through dividends.
Based on the after-tax yields, a recommended investment strategy for the Brittens could be to allocate a portion of their $40,000 into municipal bonds for stability and tax benefits, and another portion into high-yield corporate stocks for potential higher returns. The specific allocation would depend on their risk tolerance and investment goals. It's always recommended to consult with a financial advisor to create a personalized investment strategy.